Sunday, May 29, 2011

I advocate a slow, steady growth path for money expenditures on final goods and services. I favor a growth rate equal to the trend growth rate of potential income--the productive capacity of the economy. The result should be a trend growth rate of money incomes equal to the trend growth rate of real income and a price level for final goods and services that is stable on average.

The Federal Reserve, however, favors having slow, steady price inflation. In their view, the CPI should rise about 2 percent a year from where it happens to be. If there is some error, or as they like to describe it, surprise, perhaps causing the price level to rise 4% in a year, then it should just increase at a 2 percent rate from there. In other words, the growth path for the CPI is unachored, but the growth rate is kept rising at 2 percent.

Leaving aside the unanchored path, why not have persistent inflation?

I believe that persistent inflation leads to the phenomenon of explicit or implicit cost of living pay increases. These cause no problem if the economy always remains in equilibrium. Equilibrium money wages increase with the increase in equlibrium real wages plus the inflation rate.

But suppose there is an adverse aggregate supply shock. With money expenditure targeting, the growth path of nominal incomes remains unchanged. The adverse aggregate supply shock causes the price level to move to a higher growth path, and as that adjustment occurs, the inflation rate is higher. Real incomes, including real wages, shift to a lower growth path. This reflects the reduction in productivity.

If the supply shock is permanent, then the price level remains stable at a higher level. If, on the other hand, the supply shock is reversed, then there would be tempory deflation and the price level would revert to its initial value.

Suppose, however, that workers demand "cost of living increases." More importantly, suppose employers believe that they must provide such increases in order to keep and continue to recruit good workers. While the experience of employers and employees is that cost of living increases generally work smoothly, with each firm able to pass on the added costs in the form of higher prices along with growing real sales, with an adverse aggregate supply shock, this is not true.

If employers seek to increase money wages to compensate for the higher inflation, and money expenditures remain on target, the resulting decrease in real expenditures will cause reduction in production and employment. While an adverse aggregate supply shock inevitably has adverse effects on production and might also adversely impact employment because of a need to reallocate labor, trying to avoid the reduced real income by raising money wages and prices is impossible.

Recently, there has been some concern that the run up in food and energy prices might be reflected in rapid increases in wages. If that occurs, it will begin a wage and price spiral. To avoid this, some argue that the Fed should tighten monetary policy to prevent the increase in food and energy prices. A rather unpleasant prospect with unemployment remaining near double digits.

But if the Fed has a policy of having the purchasing power of money drop continuously, and raising wages to compensate for that inflation generally has no adverse impact, should a tendency for employers and employees to raise wages due to a "higher cost of living" be a surprise? Further, with the unachored growth path for the CPI, an error that leads to an excess supply of money and an increase in aggregate demand will result in a higher equilibrium growth path of prices and wages. Here again, compensating workers for the higher cost of living is appropriate.

Consider instead a world where prices are usually stable, and when they rise to a higher level, this implies an adverse aggregate supply shock and any effort to raise money incomes and prices to offset this will have adverse consequences. Here the lesson is that employers are not in a position to compensate employees for higher prices with higher wages.

In my view, what employers and employees should learn is that inflation and higher prices is the result of slow growth or even decreases in productivity. The "answer" is efforts to enhance productivity--for example, working more or harder.

Presumably, if all markets clear like the stock market, there is no problem. Wages will only rise with the trend rate of inflation or shocks to aggregate demand. They won't rise when there is an adverse shock to aggregate supply. Unfortunately, I don't think that is the world in which we live.

Saturday, May 28, 2011

For many years, I have advocated targeting a growth path for money expenditures and have come to believe that GDP is the least bad measure. However, considering the possibibility of catastrophic supply shocks, perhaps per capita GDP is a better target. (David Beckworth often looks at per capita spending.)

Even if there is a sharp drop in labor productivity, higher prices at given levels of nominal incomes seems like a reasonable way to signal to reduction in real incomes. However, if we imagine the population falling by 10 percent, there seems to be little point in having per capita money incomes rise by 10 percent along with prices.

During the Great Moderation, like GDP, per capita GDP remained very close to a trend growth path. The growth rate, however, was slightly lower--4.3 percent.

With the arrival of the Great Recession, per capita GDP first grew more slowly and then fell sharply in the second half of 2008. It's value in the fourth quarter of 2010, $47,812, is nearly 11.6 percent below the trend growth path. The value consistent with that growth path would be $54,068. To return to the growth path of the Great Moderation by the first quarter of 2012, the value would need to be $57,071, more than 19 percent higher than its value in the fourth quarter of 2010.

Of course, the growth path of the Great Moderation was inflationary. To move to a growth path consistent with stable prices in the long run, a slower growth rate is necessary. And so, parallel to my proposals for a modified target for GDP, I have calculated a modified target for per capita GDP. Starting with the growth path of the Great Moderation, it shifts to a 1.9 percent growth path in the fourth quarter of 2007.

The value of that adjusted growth path is $49,974 in the fourth quarter of 2010, so per capita GDP was 4.3 percent below target. The target for the first quarter of 2012 is $51,175, and so would require a 7 percent increase from the fourth quarter of 2010. That would be 5 quarters of growth at a 5.6 percent annual rate. This has happened before, for example, between the fourth quarter of 1984 and the first quarter of 1986.

According to the CBO, potential real GDP in the first quarter of 2012 will be $14,455 billion. If the population grows at its 1.1 percent trend growth rate over the period, then the level of GDP consistent with the target for per capital GDP in the first quarter of 2012 will be $16,137 billion. The price level (GDP deflator) consistent with real expenditure matching productive capacity would be 112, only slightly higher than its current value of 111.7.

Saturday, May 21, 2011

Critics are blaming the Fed for high gasoline prices. The argument is that quantitative easing has caused the dollar's exchange rate to fall, and so imported goods, like crude oil, are more expensive. The higher crude oil prices are passed on in higher gasoline prices.

There is an element of truth to this argument.

Suppose the economy begins in equilibrium, and as a bolt from the blue, the Fed decides to increase the quantity of money. This creates an excess supply of money. What is the market process that causes the real quantity of money to adjust to the demand to hold real money balances?

How does the Fed expand the quantity of money? The usual approach is an open market purchase of government bonds. Since the Fed is purchasing bonds, the direct and immediate effect is an increase in the price of the bonds and a decrease in their yield. The "interest rate" decreases. (Of course, it is possible that expectations of the impact of the increase in the quantity of money might cause others to sell more bonds than the Fed buys. Interest rates could conceivably rise. Still, a lower short term interest rate is plausible enough and, frankly, is the most plausible explantion of how central banks target short term interest rates.)

Assuming the interest rate paid on money itself does not adjust instantly (perhaps because it is fixed at zero for hand-to-hand currency,) the lower interest rate reduces the opportunity cost of holding money, and so raises the real demand for money to match the new, increased quantity of money.

However, in an open economy, the reduction of domestic interest rates creates an incentive for domestic investors to purchase foreign bonds instead of domestic bonds and for foreign investors to do the same. Domestic investors sell dollars for for foreign currencies and foreign investors buy fewer dollars with foreign currencies. The increase in the demand and decrease in the supply of foreign currencies raises their dollar prices. And this is a decrease in the exchange rate of the dollar.

Note that this element of the interest-elasticity of the demand for dollar denominated bonds--a shift from dollar-denominated bonds into foreign bonds--dampens the impact of the open market purchase on interest rates. In the limit, the demand for domestic bonds could be prefectly elastic with regards to the domestic interest rate, and so, there would be no impact on dometic interest rates and instead only a decrease in the exchange rate.

The decrease in the exchange rate of the dollar should result in an increase in the prices of imported goods. To the degree imported goods have prices set in terms of some other currency, and those prices are sticky, then the increase in the prices of imported goods is proportional and automatic. For a small economy, whose demand and supply of the imported goods is small relative to the market, and where prices are likely to be quoted in foreign currencies, the effect is much the same. (For crude oil, none of these conditions hold for the U.S. The price is quoted in dollars, is flexible, and U.S. demand for oil is a significant part of world demand.)

Assuming the conditions hold for a decrease in the exchange rate to result in higher import prices, then other things being equal, this increases the price level, and involves increased inflation as the price level moves to a higher growth path. The higher price level reduces the real quantity of money, bringing it into equilibrium with the demand to hold money.

However, the increased prices of imported goods will raise the demands for import-competing goods. Further, the decrease in the exchange rate reduces the prices of exported goods to foreign purchasers. This increases the demands for those goods at a given dollar price. And so, the decrease in the exchange rate raises the demands for domestically-produced output.

For this thought experiment, the economy started in equilibrium, which would include the real demand for currently-produced output being equal to the productive capacity of the economy. If that is true, then an increase in the demand for the products of import competing industries and exported goods should result in shortages of goods and so higher prices of the goods and the resources needed to produce them, including labor.

However, it is likely that firms will expand production and employment temporarily in response to an increase in demand--causing output to raise above potential and the unemployment rate to fall below the natural unemployment rate.

The higher prices of both export and import competing products, combined with the higher prices of imported goods, combine to reduce the real quantity of money, returning to its intial level. Any temporary increase in aggregate output implies an increase in real income. Assuming money is a normal good, that raises the demand for money.

However, these increases in output are temporary, and more or less by definition, firms will raise prices enough so that the real demand for output returns to productive capacity. As the dollar prices of import competing goods rise, no longer are they bargains relative to imports, and so their real demands fall again. As the dollar prices of exports rise, no longer are they bargains for foreigners, and so their real demands fall.

Once the price level rises enough for the real quantity of money to fall back to the demand real money balances, any remaining decrease in interest rates is reversed, and real expenditures on imports and exports return to their initial values. However, the exchange rate remains lower, because the prices of domestically produced goods, including both exports and import competing goods, are higher.

This is a pretty simple analysis, but it does cause reason to believe that a bolt from the blue increase in the quantity of money would tend to cause the exchange rate to drop and result in a higher prices of imported goods, and so a higher price level, and so a higher infation rate for a time. The prices of other goods and services will sooner or later catch up. In the end, the result is simply a higher price level (or growth path of prices.) The real exchange rate, real imports, and real exports are not effected in the long run. Nor are real interest rates, real output, or employment. The price level is higher and the nominal exchange rate is lower.

However, there are plenty of other scenarios that would result in a lower exchange rate, an increase in the prices of imported goods, and so a higher price level. For example, a decrease in the demand for investment and an increase in the supply of saving. A decrease in the demand for investment means domestic firms are purchasing fewer capital goods at an given real interest rate. An increase in the supply of saving is a reduction in the demand for consumer goods at any given real interest rate.

These reduce the natural interest rate. As before, this creates an incentive for domestic investors to purchase fewer domestic bonds and more foreign bonds. Similarly, there is less incentive for foreign investors to purchase dollar-denominated bonds. Again, as before, the increase demand for foreign exchange and decrease in the supply results in increased prices for foreign currencies. The dollar falls in value. And, as before, this effect reduces the impact of the change in saving and investment on the domestic (natural) interest rate.

As before, the lower exchange rate raises the prices of imported goods. And the increase in the prices of imported goods raises the demand for import competing goods. And, as before, the lower exchange rate raises the demand for exports. Just as before, there is an increase in the demand for output.

However, in this situation, these added demands for output are offset by the initial decrease in the demand for investment and incease in the supply of saving. That is a decrease in the demand for capital goods by domestic firms and a decrease the demand for consumer goods by domestic household.

If no imbalance between the quantity of money and the demand to hold money develops, then the result is a complete offset, with expenditures on domestically produced output remaining unchanged. Spending on consumer goods falls, but spending on domestically produced consumer goods remains unchanged or even rises. Spending on capital goods by domestic firms falls, but spending by foreigners on capital goods may fully offset that change.

To the degree that interest rates do change and the interest rate on money doesn't change, this process would result in an increase in the demand to hold money. And, of course, it is possible, that an increase in the demand to hold money happens to occur at the same time.

For example, suppose the President of the U.S. says that another Great Depression is eminent if certain legislation doesn't pass. Opponents doubt that the legislation will help. It fails at first, then finally passes. Polling shows that a majority of Americans believe that another Great Depression is likely or very likely. There is simultaenously an increase in the demand for money, an increase in the supply of saving, and a decrease in the demand for investment.

The equilibration of the change in saving and investment includes a lower exchange rate, higher import prices, and an expansion of the demands for both exports and import-competing goods. Presumably, it also involves a lower interest rate, which should dampen the decrease in investment demand and increase in saving supply.

If the Fed is targeting the quantity of money, it could just ignore all of this. Eventually, the prices of domestically produced goods and services, and resources such as wages, will fall enough so that the real quantity of money will rise to match the demand. The real interest rate will fall to the new natural interest rate as will the real exchange rate. The relative prices of imports will rise and import competing and export industries will expand as before.

Unfortunately, until prices and wages make the necessary adjustment, real output will remain below capacity and there will be unnecessarily large levels of unemployement of labor and other resources.

And finally, if the Fed chooses to target the exchange rate because the lower exhange rate causes higher import prices and so a higher price level, then the Fed will have to contract the quantity of money (or if the demand for money is already rising, just fail to expand it enough) and as above, prices and wages will eventually move down to a lower growth path, and real interest rates and the real exchange rate will fall. The relative prices of imports will be higher and import competing and export industries will expand.

Now, which sort of scenario is more likely? Did the Fed just expand the quantity of money as a bolt from the blue? Or have there been some changes in the fundamentals--the real demand for money, the supply of saving, and the demand for investment?

For me, the answer is simple. Money expenditures on domestic output remain well below the trend of the Great Moderation. The Fed's monetary policy of the last few years isn't a bolt from the blue hitting an economy in equilibrium. Rather, it has been too little and too late.

What the Fed should do is target a growth path for GDP, and let the quantity of money, interest rates, and the exchange rate change however much is needed to clear markets. Targeting interest rates, the exchange rate, the GDP deflator (the prices of domestically-produced goods) or the CPI (which includes imports) are all wrongheaded.

Tuesday, May 17, 2011

The Fed should explicitly target GDP for the first quarter of 2012 at $16.2 trillion. Well, that is my position. This target is on a growth path that has a three percent growth rate beginning at the level of GDP consistent with the trend of the Great Moderation (from 1984 to 2007).

Some have criticized this particular growth path as arbitrary.

While I don't think it is entirely arbitrary, as can be seen by how closely the new growth path matches the actual path of GDP before the GDP collapse in the fall of 2008, I will grant that some slightly different path might be equally good or better.

If the Fed did adopt this target, then it would be committing to having GDP (spending on domestically produced final goods and services) grow 7.7 percent between the first quarter of 2011 and the first quarter of 2012. Such a growth rate is not unprecedented.

Real GDP for the first quarter of 2011 was $13.4 trillion. According to the CBO, potential GDP in the first quarter of 2012 will be $14.5 trillion. For real output to return to potential, it would need to grow 7.6 percent over the next year.

The price level as measured by the GDP deflator was 111.7 for the first quarter of 2011 . If GDP hit the proposed target of $16.2 trillion in the first quarter of 2012 and real GDP reached potential, then the GDP deflator would need to be 111.8. Such a slight increase is tantamount to a stable price level.

The target growth path of GDP, however, continues to grow from that point at a 3 percent annual rate. According to CBO estimates, the growth rate of potential output will continue to be lower than the long run trend for a substantial period of time, so the price level consistent with the target and potential output would rise. By the first quarter of 2013, it would be 113 and by the first quarter of 2014, it would be 113.5.

So, the adjusted growth path for GDP is consistent with closing the entire output gap (as estimated by the CBO) and a stable price level over the next year. However, if inflation doesn't drop to zero immediately, there is room for a somewhat less rapid disinflation.

Sunday, May 15, 2011

David Beckwoth recently linked to some criticisms of "hard money advocates" by Paul Krugman and some other blogs--such as Rortybomb. Beckworth agreed that some "hard money advocates" have made statements worthy of criticism from the quasi-monetarist point of view. Krugman responded, saying that he feels Beckworth's pain.

Beckworth and a few others are trying to keep the spirit of monetarism alive. What I mean by that is that, like Friedman, they’re trying to reconcile a conservative view of government’s proper role with a bit of macroeconomic realism. They accept that a recession represents a huge market failure demanding policy action. But they want to keep that policy action narrowly technocratic, limited to open-market operations by the central bank.

Beckworth's response to Krugman was fine. Krugman had gone on to claim that the liquidity trap was real, and that open market operations in T-bills become ineffective with the short term nominal interest rates hit zero.

Beckworth explained, correctly, that while purchases of zero-nominal interest T-bills by the Fed might not do much good, that just means that the Fed should buy other sorts of financial assets. The point is to increase the quantity of money to meet the demand to hold money, or more exactly, what the demand to hold money would be if nominal expenditures on output were on target.

Beckworth also properly emphasized perhaps the most important change in emphasis for quasi-monetarists relative to the emphasis of orthodox monetarism. An explicit target for a growth path of money expenditures on output will do wonders in dampening actual fluctuations in money expenditures while avoiding any problems with the zero nominal bound on short and safe financial assets. It seems likely, in practice, that nothing more than a willingness to purchase long term or risky bonds would be necessary, and that liqudity traps can be avoided and only modest open market operations with ordinary T-bills would be necessary to keep money expenditures on an explicitly announced growth path.

Beckworth correctly points out that worries about the zero nominal bound are mostly about using the federal funds rate as an operating target. But there is more. Complicated rules about a somwhere between difficult and impossible to measure output gap along with keeping the expected price level rising two percent from wherever it happens to be now, are bad enough. Worse is the reality--generalities about high employment consistent with a commitment to stable prices that is obviously not taken literally. What the Fed is really trying to do is anyone's guess. Technocratic something or other.

Krugman's actual point was to criticize what he sees as the excessive conservatism of the Republican party. His oft-repeated, erroneous criticisms of quasi-monetarism were an aside. No, Beckworth and others (like me) supposedly have no political home, because the Republican party has given up on the tradition of Milton Friedman and has headed off into the the fever swamps of right wing extremism.

Of course, a few years ago, it would be difficult to imagine Krugman paying Friedman any kind of complement, if only a modest one. What I find most interesting is how this shows Krugman's extreme partisan focus. For him, it is all about the struggle between his heroic blue team and the wicked red team.

As someone who has always admired Milton Friedman, the notion that the Republican party of past years was devoted to implementing his libertarian policy preferences is a sad joke. I don't have a home in the Republican party? That is neither news nor is it a problem. I don't need to be on a political team, and I feel lucky when Republican politicians promote any halfway libertarian policy.

That the Tea Party has compelled the Republican party to at least rhetorically endorse a slightly more responsible fiscal policy, especially relative to the spend and borrow years of the Bush administration, is good news as far as I am concerned. How that all plays out will be seen as time passes. But what of monetary policy?

Beckworth linked to a post at Rortybomb, where Mike Konczal quoted a statement from the Club for Growth:

One of the pillars of economic growth is stable money – the most important responsibility of the Federal Reserve Board….

According to Konczal (and Krugman,) this is right wing quackery. But I heartily endorse that view, and would make it stronger-- the Federal Reserve's sole responsibility should be sound money.

The Club for Growth continued to criticize Fed-board nominee Peter Diamond:

While the Fed should be an independent institution to ensure sound money, Diamond is an activist-Keynesian who believes in a much larger role for government involvement in the economy. Most notably, he supported a larger stimulus than the failed one that passed into law in 2009. And he supports government-run healthcare administered through agencies similar to Fannie Mae and Freddie Mac….

I agree with the Club for Growth that if Diamond supports all of those things, then it does cast doubt upon his judgement. (On the other hand, from what I know of Diamond, there could be worse choices for the Board of Governors.)

And this leads to Krugman's claim that quasi-monetarists favor a "technocratic" approach to solving the "market failure" of recession. I think having the Fed implement some technocratic policy to do good is a mistake. Like many advocates of "sound money," I favor constitutional monetary reform to restrict the discretion of the technocrats at the Fed.

One reason I describe myself as a quasi-monetarist is because I believe the goal of such a reform is a stable growth path for money expenditures on output. I have given up on finding some good measure of the quantity of money and having some rule to control it, and have become very skeptical of an rule aimed at finding some appropriate measure of the price level and controlling its level or trajectory. I remain skeptical of a return to a gold standard.

Finally, while it would be nice if the market system was so good that it could overcome any interference created by wrongheaded government intervention, that is an unrealistic standard. As long as the Fed monopolizes the issue of base money, any recession due to a drop in money expenditures on output is a government failure--one that must be laid at the door of the Fed.

I admit, however, that it is likely that any fully private alternative monetary system would have similar problems to some degree--perhaps a larger degree. If we did have a privatized monetary system, then any recession due to a drop in money expenditures would be a market failure. But that isn't the world in which we live.

The preliminary GDP figures for the first quarter have arrived. With a growth rate of 3.61 percent, money expenditures continue to fall furtherbehind the trend growth path of the Great Moderation. However, they do make very slight progress in moving towards my preferred adjusted noninflationary growth path. (GDP is nominal GDP, Real GDP is GDP corrected for inflation.)

GDP is currently at just more than $15 trillion. If GDP had continued on its growth path of the Great Moderation (defined here from the first quarter of 1984 until the fourth quarter of 2007,) then the current value would be approximately $17.3 trillion. GDP is currently 13.6 percent below that trend growth path, and that gap has continued to grow. The target for that growth path in the first quarter of 2012 is approximately $18.4 trillion. To reach that target, the growth rate from the first quarter 2011 to the first quarter 2012 would need to be 21 percent.

My preferred modified target involves moving to a slower, 3 percent growth path starting in the second quarter of 2007. The current value of that target growth path is approximately $15.7 trillion. GDP remains 4.3 percent below target. The target for the first quarter of 2012 would be approximately $16.2 trillion. To reach that growth path over the next year, the growth rate from the first quarter of 2011 to the first quarter of 2012 would need to be 7.6 percent (not unusual for strong recoveries, such as in the early eighties.) Of course, once the growth path is reached, the growth rate would then be three percent.